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A Closer Look at Market Vectors' New BDC Income ETF

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In investors’ never-ending quest for high yield securities, many have taken a closer look at BDCs for exposure. These Business Development Companies have often been overlooked by many, but are seeing more interest thanks to their big income payouts, and the potential for capital appreciation.

Their availability in the ETF world was extremely limited though, as only a single ETN was available (BDCS - ETF report) in the unleveraged space, although another was in the 2x market (BDCL - ETF report). Still, the unleveraged product pays out roughly 9.8% in annual yields making it a very intriguing option for yield-centric investors.

These ETNs do look to have a new competitor in the space though, as Market Vectors has just released the very first BDC product structured as an ETF. This new fund, the BDC Income ETF (BIZD - ETF report), looks to track the Market Vectors US Business Development Companies Index and could present an interesting option for those curious about the BDC space (read Three Excellent Dividend ETFs for Safety and Income).

BDC Income ETF in Focus

The ETF looks to invest in a variety of BDCs which are traded in the American market. These BDCs generate income by lending to, and investing in, private companies that are generally below investment grade or are not rated, allowing for a high rate of income.

In total, BIZD invests in 26 firms with a relatively high level of concentration in the top names. Ares Capital (ARCC - Snapshot Report) and American Capital (ACAS - Analyst Report) both account for over 15% of total assets, while the next three firms combine to account for roughly 18% as well.

Investors should also note that the portfolio is relatively skewed towards pint sized securities, as large caps make up 0% of the fund, while mid caps account for 54% of assets. Dividends are expected to be paid on a quarterly basis and could come in at 7.6%, based on the observed annual index yield we say for the end of January.

Expense Ratio Conundrum

Investors should also note that this is one of the more unique products out there from an expense ratio perspective. The direct expenses come in at 40 basis points a year, and are capped to stay there until September of 2014.

This probably isn’t telling the full story though as according to Van Eck, these acquired fund fees and expenses are not borne directly by the fund. Instead they reflect the Fund’s pro rata share of indirect fees and expenses incurred by investing in BDCs.

The reason for the disclosure like this stems from an SEC rule that was adopted on funds-of-funds back in 2006. This rule requires firms to report a total expense ratio in prospectuses that accounts for both expenses paid directly out of its assets, as well as the expense ratio of the underlying funds in which it invests (read Can You Beat These High Dividend ETFs?).

According to a press release by Van Eck “the disclosure of the fund’s indirect expenses in the fund’s fee table is contained in the acquired fund fees and expenses line item. This disclosure is designed to provide investors with a better understanding of the actual cost of investing in a fund that invests in other funds, which have their own expenses that may be as high, or higher, than the acquiring fund’s expenses.”

The press release continued “Accordingly, the prospectus for BIZD discloses its AFFE which is expected to be 7.16%. However, because these fees are not borne directly by the Fund, they will not be reflected in the expense information in BIZD’s financial statements and the information presented in the prospectus table will differ from that presented in BIZD’s financial highlights included in BIZD’s reports to shareholders, when available.”

While this is somewhat of a mouthful, investors should basically note that because BDCs are investment companies, BIZD is more-or-less a fund of funds in the SEC’s eyes. This means that Van Eck is required to report operating expenses of the BDCs as ‘acquired fund fees’.

This includes things like payroll and other general costs, and these are obviously not borne by the fund. They are important for a BDC’s share price, however, so investors will have to ‘pay’ for these costs in terms of stock prices as these costs will necessary reduce a BDC’s income that is available for loans and thus, eventually, profits (see 3 Excellent ETFs with More than 4% Yield).

How does it fit in a portfolio?

This ETF seems appropriate for those seeking a high income play in the relatively uncorrelated BDC ETF market. These BDCs often loan capital to firms that are very small or are otherwise uninvestable in other ways, making them an interesting way to tap into this overlooked market segment.

The fund could face some light trading volume initially though, so bid ask spreads could be wide in the beginning. However, the fund’s management fee is relatively low which should keep after-expense yields above a very impressive 7% mark, making this an intriguing income destination (read The Right and Wrong Ways to Invest in China ETFs).

Can It Succeed?

The fund does look to be a great way to play the BDC space in ETF form, while its yield will be tough to beat. The product could also be an interesting choice for those who like the ETF structure but were put off by the other two choices in the space and their ETN build.

However, the expense ratio issue could be a major sticking point for investors. While it isn’t that big of a deal once investors delve into the product, the initial sticker shock for BIZD could be high and be somewhat prohibitive to asset accumulation, at least to those who aren’t willing to look closer at the high income ETF.

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